A Study Upon The Influence Of Internal Control Quality On Debt Contract

Since Robert Hiester Montgomery proposed the theory of internal check in1912, internal control on corporate operation and investor protection was becoming more and more prominent. At the beginning of the21st century, the United States Congress passed Sarbanes-Oxley Act in July2002along with the scandal of Enron, WorldCom and Xerox. SOX Act laid down strict regulatory rules of internal control and information disclosure for listed companies, which indicate a new era of the development and application of internal control. As the promulgation of Enterprise Internal Control Basic Norms and its supporting guidance, we had established an improving system of internal control preliminarily.The essence of internal control is a control mechanism to insure enterprises’ normal business operation and development, and it can help enterprises lower transaction cost and remedy incomplete contract (Liu and Zhang,2002). Internal control can transfer signals of operating efficiency and level of asset safety of enterprises, thus it has certain validity of contract. As we all know, debt is an important source of companies’capital. Whether high internal control quality can help companies get creditors’support? Whether internal control has validity of debt contracts or not? These questions need to be answered. So the purpose of this paper is to answer these questions above by test the relationship between companies’ internal control quality and traits of debt contracts (including debt scale, debt maturity and mortgage requisition).We held that internal control quality will influence debt financing in two ways, and reflected in debt contract:on the one hand, internal control can decrease credit risk of the bank, through increasing of group decision making and decreasing of opportunistic behaviors; on the other hand, internal control can reduce adverse selection followed by information asymmetry, through increasing communication and ensuring the financial report. Based on the analysis above, this paper tried to test whether high internal control quality can help companies get more loans, longer loan maturity and less mortgage requisition. Besides, around this main line, this paper also studied the difference of the influence above, based on different nature of property rights and financial developing level.Through literature review, theory analysis and empirical test of the content above, our paper come up with conclusions as below:(1) Related to companies with low internal control quality, the companies with high internal control quality can obtain more loans, longer loan maturity and higher proportion of bank credit debts. This indicates that internal control can help companies improve debt-financing capability and that strengthened internal control disclosure mechanism can contribute to investor protection.(2) The quality of internal control has a more significant influence in non-state owned holding companies than state-owned holding companies. As state-owned enterprises can get the governments’implicit guarantee, banks may not have the incentive to pay attention to the debtor’s internal control quality as well as its insurance and regulatory function. While for private enterprises, the situation in just reversed.(3) In the areas of lower financial development, internal control quality has a more positive influence on debt contract. In the areas of lower financial development, banks have poor capabilities to collect information, which lead to a stronger demand for internal control. Therefore, in the process of the formation of the debt contract, the positive influence of internal control is more significant. However, in the area of higher financial development, the government does less intervention in the banking industry, the marketization of this industry is of high degree, which prompts banks to improve the ability of information collecting and strengthen the supervision. In this situation, banks don’t consider much about companies’internal control quality.The main contributions of this paper are as follow:it tested the economic consequences of internal control in debt financing, which offered a theory explaining companies’motivation to improve internal control quality, and threw light on the internal control system construction; on the other hand, it studied the stakeholder protection effect of internal control in the perspective of debt contract, and the usefulness of internal control quality in debt contract, which might make a contribution in related field.The limitation of this paper lies in:due to limited access of internal control index, this paper only examined the data of Shanghai and Shenzhen A shares in the mainboard for the year of2011, the sample size is relatively small. Other affecting factors from inherent, outside, microcosmic or macroscopic may also influence debt contract, however, we just considered part of them, which might cause bias. Besides, our empirical study only tested the relationship between the quality of internal control and loan scale, loan maturity and mortgage requisitions, but didn’t involve specific mechanisms, so the related questions remains to be solved.